by Nick Gromicko, CMI®
Reverse mortgages are a means to convert part of the equity in a home into cash without having to sell the home or take on additional monthly bills, as required by home equity loans and second mortgages. Reverse mortgages are among the fastest-growing financial products today, as many older Americans who own their homes outright are learning to use these particular loans for a variety of purposes, from financing home improvement projects or paying off a current mortgage, to healthcare expenses or supplemental income.
In fact, the National Reverse Mortgage Lenders Association estimated in 2008 that there would be well over 200,000 such loans that year, up from just 157 in 1990. The reason for this increase is partly due to the enormous reservoir of potential funds in the form of equity ($4 trillion among seniors, in 2008), balanced against rising medical costs and daily living expenses.
What is a reverse mortgage?
A reverse mortgage is essentially what it sounds like: instead of borrowing money from the bank to purchase a home, a homeowner borrows money against the equity of their current home. The amount available to the homeowner depends upon their age, how much their home is worth, and current interest rates. Reverse mortgages can pay out in one or more of the following three ways:
- a single, lump sum of cash;
- a regular, periodic payout; or
- a credit line to be accessed whenever it is needed.
Also, reverse mortgages are offered in the following three forms:
- Home Equity Conversion Mortgages (HECMs), which are insured by the U. S. Department of Housing and Urban Development (HUD). These generally provide larger loan advances at a lower total cost compared with other reverse mortgages. Approximately 90% of reverse mortgages are HECMs;
- single-purpose reverse mortgages, which are offered by some state and local governmental agencies and nonprofit organizations. These are generally inexpensive, but they are not available in all areas, and they can be used only for one purpose specified by the lender; and
- proprietary reverse mortgages, which are private loans that are backed by the companies that develop them.
What's the difference between a reverse mortgage and a home equity loan?
While reverse mortgages and home equity loans, also known as a second mortgages, are both based on home equity, reverse mortgages are distinct in the following critical ways:
- There are no income or credit requirements. These proofs that the borrower can repay the loan are unnecessary when requesting a reverse mortgage, as the proof is solely the tangible equity of the house itself. Thus, reverse mortgages are popular for senior citizens who are house-rich but income- or credit-poor.
- There are no required monthly payments. Only when the borrower dies, sells the home or moves away does the money become due. Of course, borrowers are still required to pay real estate taxes, utilities and other expenses.
- A reverse mortgage provides home security. The lender cannot remove the homeowners from their properties, as is done in foreclosures, as long as they stay current with their property taxes, insurance, and home maintenance fees.
- The homeowner cannot outlive their equity. The accrued principal and interest come due when the borrower either moves out of his or her home for longer than 12 months, sells it, or dies.
- The reverse mortgage provides a "nursing home clause" that guarantees that if the borrower has to move into a nursing home or other medical facility, he or she has up to 12 months before the loan becomes due.
- HECMs, which account for the majority of reverse mortgages, require applicants to meet with an independent counselor who will explain the loan’s costs, financial implications and alternatives. This requirement improves the chances that the borrower will make an informed decision.
However, reverse mortgages have the following inherent risks:
- There are substantial upfront fees, such as closing costs (appraisal, title and escrow), origination fee and a servicing fee. These charges can be paid years later when the loan is due, however, resulting in no immediate burden to the borrower.
- Eligibility for state and federal government assistance programs, such as Medicare, may be jeopardized because the money received from the reverse mortgage counts as income.
- Once equity is withdrawn from the home, there will be less money to pass on to heirs once the home is sold and the loan is repaid.
- The interest rate for reverse mortgage may be tied to a volatile financial index, as are FHA loans and traditional mortgages.
To be eligible for a reverse mortgage, you must:
- be a homeowner 62 years of age or older;
- own your home outright, or have a low mortgage balance that can be paid off at closing using proceeds from the reverse loan; and
- live in the home. To receive an HECM, the homeowner must live in a one- to four-unit home with one unit occupied by the borrower.
Eligibility for HECM and other reverse mortgages might require that your home be in structurally good condition and free of major problems, such as termite damage and roof leaks. An InterNACHI inspector should be hired to check for these and other defects.
A word about misinformation…
Cash-strapped and uniformed seniors should be wary of brokers and advertisements that claim that reverse mortgages as tax-free. Make no mistake -- reverse mortgages are loans that must eventually be repaid, with interest, which is essentially a lender-imposed “tax.” Recipients of FHA loans, for instance, are also free from government taxes on their loan, but they are “taxed” by the broker who lent them the money.
Reverse mortgages offer a particular set of cash-strapped seniors an alternative, but they are not right for everyone. Seniors should educate themselves about reverse mortgages and other loan products so they can avoid manipulation by predatory lenders. While counseling on the pros and cons of a reverse mortgage is a requirement for federally insured loans — which account for the majority of loans today — this is not always adequate, and the help of a trusted friend or relative may be needed. Always be sure to read and understand every clause before you enter into a contract.
In summary, senior citizens who require extra income should consider reverse mortgages, as well as their alternatives.